In the lexicon of finance, EBITDA stands for earnings before interest, tax, depreciation and amortisation. It is a commonly reported metric among companies and is sometimes used by management teams to make companies appear more profitable than they actually are.
But making certain adjustments to a company’s earnings can still be useful in certain scenarios
In this article, I explore when should investors, and when should they not, make adjustments to a company’s earnings.
Interest expense
One scenario when it may be good to measure earnings before interest is when you are a bondholder. Bond holders need to see if a company has the capacity to pay its interest and earnings before interest is a good tool to measure profitability in this case.
Another situation to remove interest is when you are an equity investor (invested in the stock of the company) and want to make year-on-year comparisons. Interest expenses can fluctuate wildly based on interest rates set by central banks. Removing interest expense gives you a better gauge of the company’s profitability without the distorting effects of interest rates.
On the other hand, if you are measuring a company’s valuation, then including interest expense is important. This gives you a closer estimate to the company’s cash flow and the amount of cash that can be returned to shareholders through dividends.
Tax expense
Tax expense is very similar to interest expense. If you are a bondholder, you should look at earnings before tax as this gives you a gauge of whether the company can pay you your bond coupon.
Like interest rates, tax rates can also vary based on laws and tax credits. This can result in tax rates changing from year to year. If you are an equity investor and want to assess how a company has done compared to prior years, it may be best to remove taxes to see the actual growth of the company.
On the contrary, if you are valuing a company, I prefer to include taxes as it is an actual cash outflow. The company’s value should be based on actual cash flows to an investor and tax has a real impact on valuation.
Depreciation expense
Depreciation is a little trickier. Both bond and equity investors need to be wary of removing depreciation from earnings.
In many cases, while depreciation may not be a cash expense, it actually results in a cash outflow as the company needs to replace its assets over time in the form of capital expenseditures.
Capital expenditures are a cash outflow that impacts the company’s annual cash flow. This, in turn, impacts the company’s ability to pay both its interest expense to bondholders and dividends to shareholders.
In some cases, depreciated assets do not need to be replaced, or they can be replaced at a lower rate compared to the depreciation expense recorded. This can be due to aggressive accounting methods or the assets having a longer shelf-life than what is accounted for in the income statement. In this scenario, it may be useful to use earnings before depreciation.
In any case, I find it helpful to compare depreciation expenses with capital expenditures to get a better feel for a company’s cash flow situation.
Amortisation expenses
Companies may amortise their goodwill or other intangible assets over time. In many cases, the amortisation of goodwill is a one-off expense and should be removed when making year-on-year comparisons.
I think that both bond and equity investors should remove amortisation expense, if it is a one-off, when assessing a company.
In many cases, intangible assets and goodwill are actually long-lasting assets that still remain valuable to a company over time. However, due to accounting standards, a company may be obliged to amortise these assets and reduce their value on its balance sheet. In these cases, I prefer to remove amortisation from earnings.
On the other hand, on the cash flow statement, you may come across a line that says “purchase of intangibles”. If this is a recurring annual cash outflow, you may want to include amortisation expenses.
Other adjustments
Companies may make other adjustments and report “adjusted” EBITDA. These adjustments may include things such as stock-based compensation (SBC), foreign currency translation gains or losses, and gains or losses from the sale of assets.
These adjustments may be necessary to make more accurate year-on-year comparisons of a company’s core business. However, one exception may be SBC. This is a real expense for shareholders as it dilutes their ownership stake in a company.
While standard accounting is not a good proxy for the monetary impact of SBC, removing it altogether is also incorrect. It may be better to account for SBC by looking at earnings or cash flow on a per-share basis to account for the dilution.
Final thoughts
EBITDA and other adjustments made to earnings can be useful on many occasions especially when making year-on-year comparisons or if you are a bondholder. Removing non-recurring, non-cash expenses such as amortisation also makes sense when valuing a company.
However, there are also situations when it is better to use GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) earnings.
Some companies that are loss-making may conveniently use adjusted earnings simply to mislead investors to get their share price higher. This should be a red flag for investors.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.